[This post is dedicated to the guy who should have won the Nobel Prize]
I’ve occasionally argued that we should simplify the monetary system. Have the Fed simply issue currency, and adjust the currency stock to target NGDP expectations. Forget about banking. Eugene Fama got there first, in a brilliant paper written in 1983 (JME). Here’s Fama:
Patinkin (1961) shows that the real value of a unit of account can be controlled by controlling the supply of an asset that:
(a) has no perfect substitutes,
(b) pays interest at a lower rate than other assets of equivalent risk,
(c) sells at face value stated in terms of the unit of account.
Obviously currency fits the bill. Fama then argues:
Because U.S. banks must hold reserves against most of the liabilities (demand deposits, time deposits, certificate of deposit) issued to finance their lending activities, central bankers believe that control of the base implies restrictions of financial intermediation. Thus, they feel compelled to balance price level control against its perceived implications for financial intermediation. The yoke is easily broken. Reserve requirements can be dropped, or, what amounts to the same thing, banks can be allowed to hold reserves in the form of assets that pay free market interest rates. Price level control can then focus on control of the supply of currency — an innocuous activity that does not impinge on the ability of the economy to finance real activity.
Exactly! This is why we need to separate the central bank from the monetary authority. The central bank could be an agency that would regulate banks, set reserve requirements, do interbank clearing of funds, be a lender of last resort during banking crises, etc. But not monetary policy! If the Fed really wants to pay interest on the reserve balances, let them. But then don’t let them do monetary policy.
The monetary authority would adjust the supply of currency to target the price level (Fama’s goal) or NGDP (the market monetarist goal.) And most importantly that’s all they’d do. There would be nowhere to hide when things go wrong, as in 2008-09.
Our actual Fed was super busy with all sorts of banking system interventions during the crisis, which is why most economists seem to think Bernanke is some sort of hero who rescued the economy. The Fed hoped these financial system interventions would help the real economy, but it didn’t, because it had misdiagnosed the problem. It was falling NGDP that intensified the financial crisis in late 2008. It was falling NGDP that caused unemployment to soar.
In contrast, the monetary authority would be told to keep NGDP growth at 5%, and pay no attention to banking. That’s their only job, and they get fired if they screw up. Their only tool for boosting NGDP would be currency creation (and promises of future currency creation.)
Both the central bank and the monetary authority would send their profits to the Treasury, and both would have any shortfalls from their operations covered by the Treasury.
I’d love to see the monetary authority try to shove a few trillion in $5 bills down the publics’ throats.
PS. Has anyone noticed that whenever I describe someone’s paper as “brilliant,” it’s because he agrees with me? But Fama’s paper really is impressive. Kevin Hoover (who is extremely bright) published a critique in 1988 in Oxford Economic Papers. But unless I’m mistaken he completely missed the point of Fama’s paper. Currency is all you need to peg the price level.
PS. Congratulations to Alvin Roth and Lloyd Shapley.